Question

Adam Smith is often called the father of economics. His famous book, The Wealth of Nations, talks about an “invisible hand” that automatically allocates goods to the persons best able to put them to good use. The invisible hand operates through the price mechanism for goods and services, so that individuals who trade on the market, while seeking only their own good, actually allocate society’s resources efficiently.

Applied to modern capital markets, his ideas would imply that these markets would efficiently allocate investment capital to the firms that would use them most efficiently in producing goods and services for society—but only if they were left to operate without state intervention.

What benefits would be created if modern governments reduced financial regulations substantially in accordance with Smith’s thinking? From an ethical perspective, what societal costs might be created?

Answer 1

When State governments intervene in a free market where the price adjusts according to the demand and supply, in the form of taxes, subsidies, price floor, price ceiling, etc, in all of these cases, there is an area of inefficiency or deadweight loss being created due to the government intervention. So, if modern governments reduced financial regulations substantially, the benefits that would be created are that the economy can operate at the maximum efficiency level where there would be no deadweight loss.

From an ethical perspective, the social costs that would be created are that the poorest segment of the society will not get benefitted, there would be more inequality in the society and more negative externalities and less positive externalities. For example, if the equilibrium price of essential goods such as fruits and vegetables are too high, only the rich can afford to buy it while the poor people cannot. If the government does not intervene by setting a price ceiling and ration the goods among everyone equally, then the poor people might not get food, starve and die. So, here government intervention is necessary. In another case, if a factor pollutes the nearby river and the people who are living around it and not directly associated with any work of the factory would be negatively effected because of polluted water which they have to use. The factory owner would produce in excess because he would take into account only his private cost and not the social cost. Here again, if the government does not intervene by imposing taxes or pollution permits, the socially optimum quantity would never be reached.